When answering the question “What is proprietary trading?”, it is important to highlight the key point: it is an opportunity to earn money on the exchange without risking your capital. Sometimes a trader has all the necessary skills, experience, and a solid trading strategy, but lacks personal funds to trade. Proprietary trading was created precisely for such traders.
Proprietary firms operate on all global exchanges. They allocate their funds to traders with different experience and skill levels. Traders do not risk their capital, but they have to follow strict risk management rules.
Despite its apparent simplicity, proprietary trading in Forex has certain pitfalls. This article offers a comprehensive guide to making money through proprietary trading.
The article covers the following subjects:
Major Takeaways
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What is prop trading? |
Proprietary trading is when a company earns money by attracting third-party traders to trade assets in financial markets. |
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Why is prop trading so popular? |
Prop trading is popular because companies provide traders with capital in exchange for a share of their profits. In retail trading, traders can only use their personal funds. |
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How does prop trading work? |
A prop company selects the most effective traders and then provides them with funds to trade with. Profits are distributed according to a predetermined ratio. This approach suits both the firm and the trader. |
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How does prop trading differ from asset management? |
In prop trading, traders do not use their own money; instead, they use company funds, and they must comply with strict requirements. In standard asset management, traders are not supervised, which significantly increases the risk of capital loss. |
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Pros and cons of prop trading |
One of the main advantages of prop trading is the opportunity to work in the financial market without investing your own funds. However, some companies set extremely strict conditions that are difficult to meet. If you fail to meet these conditions, your contract can be terminated. |
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Prop trading restrictions |
As a rule, a company and a trader discuss trading conditions in advance, which are then strictly controlled by the company’s employees. If the conditions are violated, the trader may risk losing all profits. |
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Risks of prop trading |
Like any form of trading in financial markets, prop trading carries the risk of losing capital. There is also a risk of encountering an unethical company that may engage in fraudulent practices. |
Proprietary Trading Definition and Key Concepts
Proprietary trading is a principle of operation for financial companies whereby the main source of income is the profits of third-party traders from transactions on financial markets. The company provides its funds for trading, while taking a share of the trader’s profits.
Proprietary trading companies generate profits exclusively from transactions in the currency, commodity, or stock markets. These firms do not focus on the traditional sources of income for brokers and dealers, such as transaction fees, spreads, swaps, and others.
How Proprietary Trading Works
Although prop trading appears relatively simple and accessible, it is actually much more complex than trading with personal funds.
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Most prop trading companies provide their funds for trading to hired traders. The structure and type of the contract depend on the legislation and the company’s objectives.
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Trading can be conducted on the company’s accounts, to which the trader will be given access. The company may also replenish the trader’s trading account with its own funds.
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During the contract period, and especially at the start, a trader must follow strict rules on risk management, market liquidity, trading assets, leverage, and the amount of money they can use.
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The company usually oversees compliance with the conditions. This responsibility lies with either a risk manager or a senior trader.
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There are also restrictions on the use of trading strategies. Sometimes the company allows only technical analysis and prohibits algorithmic trading, automated trading systems, etc.
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The distribution of profits received by prop traders and the company is regulated by the initial agreement. It may be revised depending on trading performance. At the initial stage, prop trading companies do not give traders more than 20% of the profits. Later on, the trader’s share of profits may increase to 90%, depending on the trading rating and compliance with risk management.
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The company closely monitors costs and strives to minimize them. As a result, traders may experience delays in receiving their share of income (which may be frozen for a month or more) to compensate for possible losses in the next period. The company may also deduct commissions and spreads paid during the trading period from the trader’s profit percentage.
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The company selects candidates either directly or through third-party firms. As a rule, selection consists of several stages: testing, providing statements and reports from the trader’s accounts, and a trial period.
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The main problem for both candidates and the company lies in the trader selection process. Unscrupulous companies often charge a fee to pass the application process, insist on paid training, or require a deposit equal to the insurance amount. Meanwhile, some traders pass the selection process using false brokerage reports or other manipulations.
Proprietary Trading vs Hedge Funds
Let’s take a look at the features of proprietary trading and investing in hedge funds.
In prop trading, a company derives its main profit from the income of third-party traders who use the company’s money to conduct their operations. Hedge funds, on the other hand, conduct transactions in financial markets using investors’ funds. The transactions themselves are usually carried out by the fund’s employees.
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Hedge fund |
Proprietary trading |
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Investment model |
Operates by pooling money from large banks, insurance companies, and professional private investors with significant capital. |
Operates by trading financial instruments using its proprietary funds. Trading can be conducted either on the prop company’s own accounts or by transferring money to traders under their management. |
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Who performs trading |
Trades are executed by hedge fund employees. |
Trades are executed by hired traders, who receive a commission from the profits. |
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Benefits |
The fund and its employees receive fees for management and commissions for their services. |
The company generates profits from its own stock exchange transactions and does not charge any additional commissions. |
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Restrictions |
The restrictions are set by the fund managers themselves. The risk can be very high, which often leads to losses. |
Prop financial firms set fairly strict requirements for traders, and not everyone can meet them. |
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Risks |
Hedge funds have almost no restrictions on instrument selection and trading strategies. |
Prop trading firms strictly control assets, risk management, and leverage limits. |
Prop Trading and Investment Banking
Investment banking is an approach to generating profit by acting as an intermediary in transactions between companies and financial markets.
Investment banks are not focused on conducting transactions. Instead, they are interested in investment transactions in which they can act as intermediaries.
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Investment bank |
Prop firm |
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Principle of operation |
Essentially, an investment bank is an intermediary that provides financial services in capital markets. |
A prop company operates on an exchange and gains profits from buying or selling assets. |
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What transactions are carried out |
Investment bank employees act as investment advisors, intermediaries in mergers and acquisitions, and capital managers. |
Prop firms hire specialists and allocate their money to them. Traders use these funds to trade on the exchange and share a portion of their profits with the companies. |
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Benefits |
Investment banks profit from intermediation and consulting—they receive commissions for participating in transactions. |
The company earns profits from trading exchange-traded assets and does not charge additional commissions. |
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Restrictions |
Investment banks are extremely careful when selecting the parties to transactions in which they participate. The main purpose of this selection process is to minimize risks. |
Prop companies impose strict limits on traders, often capping their profit potential. |
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Risks |
Investment banks have almost no risk. All transactions are conducted within a strict legal framework, and any disputes or violations are settled in court. |
The company sets its limits independently, taking into account its risk tolerance. |
Benefits and Risks of Proprietary Trading: Volcker Rule
In proprietary trading, it is important to distinguish between the risks faced by traders and those faced by prop firms.
Risks faced by traders
Traders who work as hired staff in prop firms may become victims of fraud and scam schemes.
Nowadays, it is common to come across companies that derive most of their income from commissions and fees that are not always legal. These fees include a fee for participating in the selection of candidates and a fee for information materials. In some cases, traders are required to form insurance deposits from their own funds.
Risks of prop trading firms
The firm strives to minimize all risks. In most cases, this is handled by risk managers. However, sometimes government regulations apply to large companies. In 2010, the United States introduced the Volcker Rule, which restricts companies’ investment activities.
Volcker rule
Essentially, the Volcker Rule is an amendment to the Dodd-Frank Act on Wall Street reform and consumer protection. This rule is named after former Fed Chairman Paul Volcker.
The Volcker Rule restricts financial institutions from using their own money for speculative short-term investments in financial markets. This regulation completely prohibits banks from trading with private trading capital for their own benefit. The regulator also restricts banks’ investments in hedge funds and private equity funds.
The Volcker Rule was introduced to prevent a repeat of the mortgage crisis of 2007–2008, when numerous banks invested almost all of their available funds in mortgage-backed securities using a proprietary trading model.
Conclusion
Proprietary trading is a popular way for traders lacking their own capital to generate income. However, this method requires skills and extensive experience, both of which directly impact earning potential. This method is definitely not suitable for beginners in Forex trading.
Most proprietary trading firms hire inexperienced traders, act as training centers, and offer paid and free trading education services. For novice traders, this is a great way to test their trading skills. However, you should be very careful when choosing a prop firm. Before signing a contract, it is important to carefully study all the terms and conditions and learn more about the company. It is sometimes the case that such firms may profit from deceiving inexperienced traders rather than from trading.
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